The Secrets Behind Profitable Trading

There are two main concepts one needs to understand and maybe learn the hard way, before becoming consistently profitable:

  1. Different setups work in different markets.

The same setup that can deliver outsized profits on one trading environment might lose you money in a different market. For example, buying strong stocks in hot industries in anticipation of a breakout works great during market uptrends, but it is a system with no edge at best during range-bound markets. Buying breakouts after a few days of a general market rally in a range-bound environment is not a profitable approach. Swing trading is a lot more challenging during corrective markets when correlations between stocks are very highs, volatility is ginormous and the market changes its direction frequently. Intra-day trading is a lot more profitable during fast corrective markets than during low-volatility steady market uptrends, when swing and position trading provide more lucrative alternatives.

Edges come and go because markets are constantly changing – sometimes, in a predictable, cyclical manner; other times, in a completely new and unexpected way. The path to survive and grow is to constantly experiment with new ways to make money and protect capital.

2. The concept of holding power.

Many novice market participants trade with too much size and get easily scared out of sound positions.

Holding power comes from two things:

a) A good entry – this means picking the right setup for the current market. A good entry helps to keep our potential loss small, while it provides the opportunity to make multiples of our initial risk. Risking a dollar to potentially make three dollars per share.

b) The right position size – I risk between 0.5% and 1% of my capital depending on the market.

Leverage and trading too big have ruined not one or two accounts. I became much better and consistently profitable trader once I cut my position size to reflect my current trading capital and the current market environment. Not all markets provide equal opportunities for profit. There are times to be aggressive. There are times to protect capital and confidence.

The Hard Truth About Investing

Most people (passive and active investors) don’t get average market returns. The market averages, the S & P 500s of the world, have actually achieved a lot better than average market returns.

Many passive investors achieve below average returns because they are over-diversified, receive bad advice, and pay high fees to financial advisors. Keep in mind, many financial advisors are not in the performance business. They are in the business of providing sound financial planning services. It is not something that you cannot do by yourself, but let’s face it – most people simply lack the knowledge, the desire or the time to do it. The question is how much is a good financial advisor worth? One percent of your capital every single year? On a 500k, this is 5k a year. There should not be a big difference between allocating 500k and 5 million to index funds. Why are financial advisors not charging a flat fee after a certain minimum capital requirement is met?

Most hedge funds are not able to achieve average market returns over a long period of time after fees. 2 and 20 or even 1 and 15 can be hard to overcome if you manage a substantial amount of capital. If it is practically impossible, why should investors even bother? Considering the much bigger risk that you are taking, the leap of hope, the tax implications, hedge funds and managed accounts’ benchmarks should be a lot higher than S & P 500, the Russell 2000, the Vanguard Emerging Markets Index Fund, the S & P Global 1200, etc. So don’t gloat if your fund managed to beat the market by 200 basis points last year. You need to deliver a lot more to justify the risk people are taking with you. How much more? I’d say 1.5X their usual benchmark. The worse case scenario should be average market returns after fees with a smaller drawdown than the market averages.

What about active traders? We should take into account not only our return on capital but also our return on time and efforts spent. The time we devote to trading is a time we cannot use to acquire other skills. Therefore, we should require from ourselves a lot bigger than market average returns. 2x, 3x, 4X than what a market average can do for us. If we cannot achieve them and statistics show the vast majority of traders and investors cannot, there are better options for our time, intellect and money.

The way I see it, you have the following options:

a) Dollar-cost average in a cheap, well-diversified index fund and never read another financial article or watch financial TV.

b) Find a reasonably priced financial advisor who can earn his keep by providing a personalised financial plan. This is a good option if you are already rich and your goal is to remain rich.

c) Find smaller money managers with a great track record after fees. It is not impossible. I personally know half a dozen smaller managed account managers that have done a good job.

d) You can pay for education, strategic direction and ideas. There are quite a few amazing trading and investing services out there that more than pay for themselves. You save time, gain skill, and improve your odds of achieving substantial returns by spending very little money.

What’s Widely Considered As Safe Is Often Risky

Has it ever occurred to you that bubbles always happen in a new asset class that people don’t yet understand and have no idea how to value? Cryptocurrencies, Internet Stocks in the late 90s, Japanese debt, real estate and stocks in the 80s, gold in the late 1970s, Dutch tulips, etc.

Bubbles (trends) can last a lot longer than most can possibly imagine. They can be both wealth creators and wealth destroyers.

Recognising something is a potential bubble is not hard. Convincing yourself to participate in it is a lot more difficult.

Every bubble goes through three stages: first, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident by most people. Fear of missing out kicks in in stage three.

Every bubble needs sceptics and naysayers. Otherwise, there won’t be anyone left to buy. By the time most people feel it is safe to enter a trend, that trend is usually close to an end.

Here’s George Soros, explaining bubbles in a way more sophisticated manner:

First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times, it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, there is a lack of equilibrium conditions.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognise that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.

How To Become The Best Trader You Can Be

We have all heard the phrase “practice makes perfect”. The truth is that not all practice makes perfect. There are people who think they have ten years of experience when in fact they haven’t learned anything new after their first year.

Dr Anders Ericsson has spent 20 years studying world-class performers in various fields. Thanks to his work, we now know a lot more about how to become drastically better at anything we want to.

Ericson claims there are two types of practice – deliberate practice and good enough practice.

“Good enough” is how most of us approach any new skill. As soon as we reach a certain level of basic proficiency, we stop improving and never move beyond it.

According to Dr Ericsson, deliberate practice is the foundation of incredible skills. It has four components:

Setting goals – some say it is better to have a system than having a concrete goal. The creator of the Dilbert comics, Scott Adams says “eating healthy is a system, losing 10 pounds is a goal.” The truth is that being able to measure your improvement and achieving a set of micro-goals can be a system. People become experts by developing a series of micro skills and connecting them together. For example, an aspiring trader can work one month only on cutting his losses quickly, then another month on picking only certain setups that meet a checklist of criteria, then another month on letting his winners run, then another month on recognising the current market environment and the best setups for that environment. Every month, our trader can be laser-focused on acquiring one new skill. After a year of relentless work, he will acquire all micro skills that great traders possess.

Focus – deliberate practice requires all your attention. This means no watching movies, using social media, listening to podcasts, talking on the phone, texting, reading or snap-chatting while learning a new skill. You have to be 100% focused and immersed in one thing.

FeedbackHaving an experienced coach, who can objectively assess your improvement, correct your mistakes, highlight what you are doing right and what you are doing wrong, is an incredible plus and absolutely needed if you want to be an elite performer. Why do you think every single one of the best-ranked tennis players has a coach?
Here’s what Serena Williams says about the contribution of her coach:

No matter what, no matter what stage you’re at, you can get better, and you can’t always do that yourself. You need another set of eyes, another voice. That’s what Patrick gives me.

Here’s what Paul Annacone – the guy who coached Pete Sampras and Roger Federer says:

It is all dependent on what the players want and need. A lot of it is about figuring out your environment. There are different layers, different levels in coaching a younger player or adolescent as they develop versus the adult. I argue it becomes more complicated with the older, more accomplished players.
No matter how good you are as a player, you need to be directed, managed. You need a trusted pair of eyes because your own eyes can’t see if everything is on course. Those players have immense skills, but one of their biggest strengths is often that they are incredibly stubborn and a good coach can go in and handle that mentality.

The best hedge funds and trading firms have coaches that help their traders become the best traders they can be. Most individual traders don’t have access to those coaches, but they can find good mentors who can accelerate their learning curve and make them at least a little better.

Discomfortdeliberate practice should push you outside of your comfort zone. Never stop learning new skills, never stop improving and experimenting, figure out a system to adapt to the constantly changing market conditions.

Check out my newest book: Top 10 Trading Setups – How to find them, when to trade them, how to make money with them.

The 10 Secrets of Trend Following

The other day I posted a chart of a stock that I rode for a 50% gain in 2016. It went up another 75% after I sold. I had good reasons to sell at the time – the stock was extremely overbought on a weekly time frame and, more importantly, it had a major reversal after a strong upside move. The strongest stocks can stay overbought for a long time and they tend to have multiple 20-25% pullbacks along the way. This is why it is not easy to hold them. They can also correct through time and go through long periods of treading water. It is hard to sit on them during those periods when you watch so many other stocks trending.

Anyway, I was surprised by the strong response to my tweet and I decided to expand on my view of trend following:
  1. Trend following is easy only in hindsight. No one has a clue how long a trend can last and what profits it can deliver. No one can sell at the top consistently.

2. You have to be willing to give up 20%-25% of the gains in order to catch a complete move in a strong momentum name.

3. Holding strong stocks in a bull market can make you a lot of money but it can chop you into pieces during range bound and corrective markets.

4. There are different time frames in trend following – some use monthly, weekly, daily, hourly, 30 min or even a 5 min chart. Figure out what game you want to play in the market. Do you want to catch a dozen 50% to 100% multi-week gainers in a year or do you want to capture hundreds of short-term 5% to 20% gainers in a year? The former requires less time in front of a computer but it comes at a steep price – you have to be content with being wrong very often (more than 60% of the time) and you have to be able to stomach deep drawdowns in your portfolio. The latter approach is also known as swing trading. Its success rate varies between 40% and 80% depending on the market environment. There is not just one type of swing trading- there is buying breakouts, dips, buying in anticipation of a move, mean reversion, etc. You can learn more about my approach to swing trading in my books Top 10 Trading Setups and The 5 Secrets to Highly Profitable Swing Trading or you can watch me do it on marketwisdom.com.

5. The best time to enter a long-term trend is right after a major market correction. The second best time is after an earnings-related breakout.

6. Pay attention to industry-related moves. When an entire industry starts to break out or break down, there’s usually a strong catalyst that is likely to sustain trends for multiple months.

7. It is far easier to find a trend than to ride it long enough to make a difference in your returns.

8. Figuring out when and how to sell can be as much an art as a science. Sometimes, being a contrarian means staying with a trend.

9. It is ok to take partial profits on strength. It is ok to add to your position once it sets up properly again.

10. There is trend following on the short side as well but very few do it. Most momentum stocks give up 50% to 80% of their upside moves. Catching a top is very hard and personally, I don’t know how to do it consistently. Shorting ex-momentum stocks after they set up below their 50 or 200-day moving averages offers a lot better success rate and risk/reward.